Recognizing Good, Bad, and Toxic Debt
Credit is such an integral part of our economy that it feels completely natural to get into debt. In some instances, debt is hard to avoid entirely. How do we know when our debt is out of control?
If we want to diagnose our debt, we need to understand it. Not all debt is the same, and certain kinds of credit are better than others. Let us take a close look at the 3 types of debt.
Good Debt
Not all debt is created equal. When you use credit in a way that it will increase in value or generate sustainable, long-term income, it is the best kind of debt. What types of things fall under the umbrella of good debt?
Student loans
While the debt load taken on by students in the 21st century seems to be disproportionately growing, it is still considered to be good debt (within reason). Education is still the strongest indicator of future earning power.
Sadly, every student loan is not created equally, so you want to do some research into your educational and vocational goals. For instance, a degree in a STEM field (science, technology, engineering, and mathematics) will likely pay off a lot better than a liberal arts degree. Which means that from a purely financial perspective, a loan for the former is a better choice than the latter.
Real estate
For many people, a mortgage represents the one item in their life with the most equity. Even though it represents a high and long-term debt, it is considered good debt—provided you do not end up overpaying.
When you are talking about mortgages, it is probably smart to include Home Equity Lines of Credit (HELOC). This is credit based on your home’s equity. It is generally considered good credit because it is lower, and you can use it to do upgrades that will ultimately increase your home’s value.
Other forms of real estate—like rental or commercial properties—can be a worthwhile credit investment.
Car loans
A car loan is the most dangerous of the good debts. Vehicles depreciate fast, so you can end up owing more than the value of your purchase. If you want a car loan to remain good debt, it should not be longer than 4 years, and the payments should not be higher than about 20% of your take-home pay—and technically, you should pay at least 20% down.
Bad Debt
Unlike good debt, bad debt involves depreciating assets. These are things that you buy on credit but are worth very little by the time you end up paying them off. It is important to recognize that good credit can become bad credit fast.
Cars are a perfect example. They are so expensive and depreciate so fast that you can end up paying interest on something that is only losing its value.
Along that line, using credit to buy vacations, clothes, or meals at restaurants is just a bad idea. Paying interest on a consumable that is valueless after you have purchased it is a bad idea.
This is how most people use credit cards. The interest rate is generally too high to even warrant buying stuff that you are getting a great deal on. When you think about Christmas and other holidays, this is the debt that stacks up and ends up hurting people.
Toxic Debt
Some debt is so bad that it should be avoided at all cost. No matter what. These are things like payday loans, rent-to-own plans, title loans, and debt with incredibly high interest. What does incredibly high interest mean? We are talking about interest exceeding 100%—the average interest rate on a payday loan is 400%.
This kind of predatory credit takes advantage of people in financial straits and offers them easy to get but completely toxic financial products. If you have found yourself mired in poisonous debt, seek credit counseling immediately.
Managing debt is an integral piece of stewardship. To read more about stewardship and debt, find out post What is Stewardship and What Does it Mean to Me?
